The Impact of Liquidity and Solvency on the Use of Covenants in Corporate Bonds’ Prospectuses of the Issuers from BRICS

Abstract

Covenants provide advantages of the mitigation of an agency conflict related to debt including the such problems as underfinancing, asset substution and dilution of liabilities. At the same time covenants create costs due to the reduction of managerial and financial flexibility. Covenants serve as substitutes to some bonds’ features such as build-in call options, convertibility and the term of that also can help to mitigate the agency conflict.
In this paper there are presented the results of an empirical study of the influence of two factors of financial instability, namely liquidity and solvency, on the use of covenants in prospectuses of 225 public issues of bonds by the issuers from BRICS. We have found a statistically significant influence of solvency, i.e. the company’s ability to repay its long-term liabilities, on the use of different types of covenants. The issuers with higher solvency less frequently restrict themselves in further debt issuance, the change of management and not so often use the clause of early repayment in case of the change of the bonds’ issue rating. The prospectuses of callable bonds and bonds with S&P’s rating less that BBB- (high yield or junk bonds) contain more covenants limiting dividend payments and further debt issuance.
Our results are similar to ones achieved by other authors for the markets of the USA, China and Brazil. However, the prospectuses of the Russian issuers less often include a ban on the lease-back, the Russian companies not so often limit themselves in further issuance of debt and the management change, and don’t use the clause of early repayment of bonds in case of downgrading of a credit rating of an issue. This may be explained by the fact that covenants do not have legal force according to the Russian legislation.